Chapter 11

Optimal Portfolio
Choice & the CAPM
Ziwei Wang
Wuhan University
 The Expected Return of a Portfolio
• To nd an optimal portfolio, we need a method to describe a portfolio and
analyze its return.

• The portfolio weights are de ned by the fraction of the total investment held in
each individual investment in the portfolio.
Value if investment i
xi = .
Total value of portfolio

• Then the return on the portfolio, RP, can be written as a weighted average of the
returns on the investments in the portfolio

∑
RP = x1R1 + x2R2 + ⋯ + xnRn = xiRi.
i

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The Expected Return of a Portfolio
Problem (Example 11.1 in textbook)

Suppose you buy 200 shares of Dolby Laboratories at $30 per share and 100
shares of Coca-Cola stock at $40 per share. Dolby’s share price then goes up to
$36 and Coca-Cola’s falls to $38.

(a) What is the new value of the portfolio, and what return did it earn?

∑
(b) Show that RP = xiRi holds.
i
(c) After the price change, what are the new portfolio weights?

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The Expected Return of a Portfolio
• Intuitively, the expectation operator is linear
E[aX + bY] = aE[X] + bE[Y].
• So the expected return of a portfolio is simply the weighted average of the
expected returns of the investments within it, using the portfolio weights

[ i
∑ ] ∑ ∑
E[RP] = E xiRi = E[xiRi] = xiE[Ri].
i i

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The Volatility of a Portfolio: Two-Stock

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 The Volatility of a Portfolio: Two-Stock
• This example demonstrates two
important phenomena.

• First, by combining stocks into a

portfolio, we reduce risk through
diversi cation.

• Second, the amount of risk that is

eliminated depends on the degree to
which the stocks face common risks.

• This is the idea of hedging (对冲) in

nance. (Reading: What is a hedge
and how it works.)

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Covariance and Correlation
• Covariance is the expected product of the deviations of two returns from
their means.

Cov(Ri, Rj) = E[(Ri − E[Ri])(Rj − E[Rj])].

• To estimate covariance, we use

Cov ̂(Ri, Rj) =

1
T−1∑
(Ri,t − R̄i)(Rj,t − R̄j).
t
• The magnitude of covariance is hard to interpret: It depends on both the
volatility of individual stocks and their co-movement.

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Covariance and Correlation
• In order to separate and quantify the strength of the co-movement, we can
calculate the correlation between two stock returns
Cov(Ri, Rj)
Corr(Ri, Rj) = .
SD(Ri) ⋅ SD(Rj)

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Covariance and Correlation
Problem (Example 11.3 in textbook)

What are the covariance and the correlation of a stock’s return to itself?

Problem (Example 11.4 in textbook)

Using the data in Table 11.1, what are the covariance and the correlation
between North Air and West Air? Between West Air and Tex Oil?

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Covariance and Correlation

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Covariance and Correlation
• When will stock returns be highly correlated with each other?
• Stock returns will tend to move together if they are a ected similarly by
economic events.

• Thus, stocks in the same industry tend to have more highly correlated returns
than stocks in di erent industries.

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Covariance and Correlation

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Covariance and Correlation
• Kellogg and General Mills are really similar. Let me show you their (yucky)
breakfast choices

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The Volatility of a Portfolio: Two-Stock
• It can be shown that the covariance is linear in its arguments
Cov(aX + Y, Z) = aCov(X, Z) + Cov(Y, Z).
• Therefore, for a two-stock portfolio with RP = x1R1 + x2R2,
2 2
Var(RP) = x1 Var(R1) + x2 Var(R2) + 2x1x2Cov(R1, R2).
• We can also rewrite this equation as follows
2 2 2 2
Var(RP) = x1 SD(R1) + x2 SD(R2) + 2x1x2Corr(R1, R2)SD(R1)SD(R2).

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The Volatility of a Portfolio: Two-Stock
Problem (Example 11.6 in textbook)

Using the data from slide 12, what is the volatility of a portfolio with equal
amounts invested in Microsoft and Hewlett-Packard stock? What is the volatility
of a portfolio with equal amounts invested in Microsoft and Alaska Air stock?

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The Volatility of a Large Portfolio
• Now let’s consider a large portfolio RP = x1R1 + x2R2 + ⋯ + xnRn.
• Using linearity of the covariance, we can deduce that the variance of a portfolio
is equal to the weighted average covariance of each stock with the portfolio,

(∑ ) ∑
Var(RP) = Cov xiRi, RP = xiCov(Ri, RP).
i i

• We can further reduce the formula as

∑ ∑∑
Var(RP) = xiCov(Ri, RP) = xi xjCov(Ri, Rj).
i i j

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The Volatility of a Large Portfolio
• We can also rewrite the variance of a portfolio as

∑ ∑
Var(RP) = xiCov(Ri, RP) = xiSD(Ri)SD(RP)Corr(Ri, RP).
i i

• Dividing both sides by the standard deviation of the portfolio yields

∑ ∑
SD(RP) = xiCov(Ri, RP) = xiSD(Ri)Corr(Ri, RP).
i i

• Note that since correlations are less than 1, we have

∑ ∑
SD(RP) = xiSD(Ri)Corr(Ri, RP) ≤ xiSD(Ri).
i i

• That is, the volatility of a portfolio is less than the weighted average volatility
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The Volatility of a Large Portfolio
• As a special case, we consider an equally weighted portfolio
1 1 1
RP = R1 + R2 + ⋯ + Rn.
n n n
• In this case, the variance of the portfolio can be written as

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The Volatility of a Large Portfolio
• For example, consider an equally weighted portfolio of stocks selected
randomly from the stock market.

• The historical volatility of the return of a typical large rm is about 40%, and
the typical correlation between the returns of large rms is about 25%.

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The Volatility of a Large Portfolio
Problem (Example 11.8 in textbook)

What is the volatility of an equally weighted average of n independent, identical

risks?

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The Volatility of a Large Portfolio
Problem (Example 11.8 in textbook)

What is the volatility of an equally weighted average of n independent, identical

risks?

Does the answer look familiar?

We stated that when observations Rt are independent and identically distributed

(IID), the standard deviation of R̄ is equal to
SD(Rt)
SD(R̄) = .
Number of Observations

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Mean-Variance Analysis
• In modern portfolio theory, investors are assumed to prefer higher expected
return and lower volatility.

• That is, investors are risk averse.

• Therefore, investors seek the biggest reward at a given level of risk, or the
least risk at a given level of return.

• In a volatility-expected return space, the indi erence curves are upward

sloping.

• An investor’s utility increases in the northwest direction.

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Mean-Variance Analysis
• Such a preference over risks can be micro-founded by suitable assumptions
on the utility function and the distribution of risky returns.

• For example, we can suppose the investor has a utility function with constant
−λx
absolute risk aversion: U(x) = − e , with λ > 0.

• Also, suppose that x is a normally distributed return with mean μ and variance
2
σ .
λ 2
• An expected-utility-maximizing investor aims to maximize μ − σ .
2
• This is a standard assumption in nance theory.

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Risk vs Return: the Efficient Frontier
• Consider a portfolio of Intel and Coca-Cola stock. Suppose an investor
believes these stocks are uncorrelated and will perform as follows

• If the investor chooses a portfolio with 40% invested in Intel and 60% in
Coca-Cola. We can compute that E[RP] = 14 % and SD(RP) = 25 % .

• We can do the same calculation for all possible splits.

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 Risk vs Return: the Efficient Frontier
• A portfolio is ine cient
if you can nd another
portfolio of the two
stocks that o ers a
higher expected return
with lower volatility.

• Otherwise, it is called an
e cient portfolio.

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Risk vs Return: the Efficient Frontier
• Correlation a ects the
volatility of portfolios.

• When correlation is 1,
there is no diversi cation.

• When correlation is −1,

it’s possible to hold a
portfolio that bears no risk.

• Expected returns are

invariant to correlation.

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Risk vs Return: the Efficient Frontier
• A short position can
also be e cient.

• Short selling can greatly

increase the risk of the
portfolio.

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The Volatility of a Large Portfolio
Problem (Example 11.10 in textbook)

Suppose you have $20,000 in cash to invest. You decide to short sell $10,000
worth of Coca-Cola stock and invest the proceeds from your short sale, plus
your $20,000, in Intel. What is the expected return and volatility of your
portfolio?

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Risk vs Return: the Efficient Frontier
• In general, adding a new
asset (even one with low
return) into the portfolio
can help you diversify.

• Notice how Bore can

reduce the volatility of a
Coca-Cola+Intel only
portfolio.

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Risk vs Return: the Efficient Frontier
• When we combine Bore
stock with every
portfolio of Intel and
Coca-Cola, and allow for
short sales as well, we
get an entire region.

• The e cient portfolios

are those on the
northwest edge of the
shaded region, which we
call the e cient frontier
for these three stocks.

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Risk vs Return: the Efficient Frontier
• Ultimately, we can construct the e cient frontier for all available risky
investments showing the best possible risk and return combinations that we
can obtain by optimal diversi cation.

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Risk-Free Saving and Borrowing
• We have identi ed an e cient frontier of the risky assets from which an
investor can choose.

• If only risky assets are available in the market, then di erent investors will
optimize at di erent portfolios, depending on their preferences.

• However, we next argue that the existence of a risk-free asset (e.g. the
Treasury bills) implies that all investors choose the same optimal portfolio,
regardless of their preferences.

• This type of result is extremely powerful in economic theory.

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Risk-Free Saving and Borrowing
• Consider an arbitrary risky portfolio RP.
• Let’s construct a new portfolio where we put a fraction x ∈ [0,1] in the
portfolio, while leaving (1 − x) in the risk-free Treasury bills yielding rf.

• The expected return of this new portfolio, denoted by RxP, is then

E[RxP] = (1 − x)rf + xE[RP] = rf + x(E[RP] − rf ) .
• The volatility of this new portfolio is
2 2
SD[RxP] = (1 − x) Var(rf ) + x Var(RP) + 2(1 − x)xCov(rf , RP) = xSD(RP) .

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Risk-Free Saving and Borrowing
• This computation means there is a linear relationship between expected
return and volatility for the new portfolio we construct.

• Actually, we can choose x > 1, which means we are borrowing money at a

risk-free interest rate to invest in RP.

• This is referred to as buying stocks on margin. A portfolio consisting of a

short position in the risk-free investment is called a levered portfolio.

• If you hold a levered portfolio, you are taking a higher risk than the portfolio P
itself. But of course, you are expecting a higher return.

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Risk-Free Saving and Borrowing
• Question: What happens if we choose x < 0?

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Risk-Free Saving and Borrowing
Problem (Example 11.11 in textbook)

Suppose you have $10,000 in cash, and you decide to borrow another $10,000
at a 5% interest rate in order to invest $20,000 in portfolio Q, which has a 10%
expected return and a 20% volatility. What is the expected return and volatility
of your investment? What is your realized return if Q goes up 30% over the
year? What if Q falls by 10%?

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Risk-Free Saving and Borrowing
• We assume investors prefer less volatility and more return.
• An investor becomes unambiguously better o if she combines the risk-free
asset with a portfolio higher than P — so that the blue line is steeper.

• Mathematically, an investor should combine her risk-free asset with a portfolio

RP to maximize the Sharpe ratio:
E[RP] − rf
Sharpe Ratio = .
SD(RP)
• All investors will reach the same tangent portfolio independent of his or her
preferences, and we call this portfolio the e cient portfolio.

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Risk-Free Saving and Borrowing

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The Efficient Portfolio and Required Returns
• Because investors aim to maximize the Sharpe
ratio, we can derive a clear relationship
between expected returns of the e cient
portfolio and an individual risky asset.

• This is the idea for which William Sharpe was

awarded the Nobel Prize in 1990 (along with
Harry Markowitz and Merton Miller).

• It is the most important component of the

Capital Asset Pricing Model, which is still
widely used nowadays.

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The Efficient Portfolio and Required Returns
• Consider an arbitrary portfolio RP and an arbitrary risky asset Ri.
• We ask ourselves this question: Can we improve the Sharpe ratio by
borrowing rf and adding Ri in RP? If we can, then RP is not yet e cient.

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• Technically, we construct a new portfolio −xrf + RP + xRi where x is small.
• The expected return is E[−xrf + RP + xRi] = E[RP] + x(E[Ri] − rf ).
2 2 2
• The volatility is SD(RP) + x SD(Ri) + 2xSD(RP)SD(Ri)Corr(Ri, RP) .

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The Efficient Portfolio and Required Returns
• Taking derivatives with respect to x and evaluating at x = 0, we obtain the
change in expected return and volatility when we invest a tiny unit of Ri.

• The expected return has increased by E[Ri] − rf.

• The volatility has increased by SD(Ri) ⋅ Corr(Ri, RP).
• If this ratio is larger than the Sharpe ratio at P, i.e.
E[Ri] − rf E[RP] − rf
>
SD(Ri) ⋅ Corr(Ri, RP) SD(RP)
then we can increase the Sharpe ratio and make it steeper by investing in Ri.
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 The Efficient Portfolio and Required Returns
• Rearranging, we have
SD(Ri) ⋅ Corr(Ri, RP)
E[Ri] > rf + ⋅ (E[RP] − rf ).
SD(RP)
• De ne the right-hand-side as the required return of Ri, i.e.
P P
ri ≡ rf + βi (E[RP] − rf ), where βi is the beta of investment i to portfolio P.

• To reiterate, we have shown that increasing the amount invested in i will

increase the Sharpe ratio of portfolio P if its expected return exceeds its
required return.

• The converse is also true.

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The Efficient Portfolio and Required Returns
• Eventually, for each asset Ri, we must have
eff
E[Ri] = ri ≡ rf + βi ⋅ (E[Reff ] − rf ).
• That is, a portfolio is e cient if and only if the expected return of every
available security equals its required return.

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The Efficient Portfolio and Required Returns
Problem (Example 11.13—14 in textbook)

You are currently invested in the Omega Fund, a broad-based fund with an expected
return of 15% and a volatility of 20%, as well as in risk-free Treasuries paying 3%.
Your broker suggests that you add a real estate fund to your portfolio. The real
estate fund has an expected return of 9%, a volatility of 35%, and a correlation of
0.10 with the Omega Fund.

(a) Will adding the real estate fund improve your portfolio?

(b) Suppose you have $100 million invested in the Omega Fund. In addition to this
position, how much should you invest in the real estate fund to form an e cient
portfolio of these two funds?

(c) Verify that, at the e cient portfolio, the expected return of the real estate fund is
equal to its required return.
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(a) Will adding the real estate fund improve your portfolio?`
(b) Suppose you have $100 million invested in the Omega Fund. In addition to this position, how much should
you invest in the real estate fund to form an efficient portfolio of these two funds?
The Capital Asset Pricing Model
• Given the e cient portfolio, we can compute the expected return of any
security based on its beta with the e cient portfolio.

• However, to obtain the e cient portfolio, we need to know the expected

returns, volatilities, and correlations between all investments…

• This is clearly unrealistic.

• It turns out that, under a set of assumptions, we can identify the e cient
portfolio without actually computing it.

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The Capital Asset Pricing Model
• There are three assumptions underlying CAPM
• First, markets for assets are competitive. Investors can buy and sell all
securities at competitive market prices (without incurring taxes or transactions
costs) and can borrow and lend at the risk-free interest rate.

• Second, investors are rational. From our theory, they hold only e cient
portfolios of traded securities—portfolios that yield the maximum expected
return for a given level of volatility.

• Third, expectations are homogeneous. Investors have homogeneous

expectations regarding the volatilities, correlations, and expected returns of
securities.

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The Capital Asset Pricing Model
• If expectations are homogenous, investors will choose the same e cient
portfolio.

• If all investors demand this e cient portfolio, the e cient portfolio is the total
demand of risky securities.

• The total supply of risky securities is the market portfolio.

• In equilibrium, the demand must be equal to the supply, so the e cient,
tangent portfolio of risky securities is the market portfolio.

• Note that this is an equilibrium theory.

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The Capital Asset Pricing Model
• The tangent line going through the market portfolio is then called the capital
market line.

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The Capital Asset Pricing Model
• We can now de ne the beta of a security with respect to the market portfolio
SD(Ri) ⋅ Corr(Ri, RMkt) Cov(Ri, RMkt)
βi = = .
SD(RMkt) Var(RMkt)
• It measures Ri’s sensitivity to market risk. (For every 1% change in market
return, how much would Ri change in expectation.)

• The CAPM equation can nally be stated as

E[Ri] = ri = rf + βi ⋅ (E[RMkt] − rf ).
• Q: Would it be rational for you to hold an asset that has a negative beta?
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The Capital Asset Pricing Model
• The CAPM equation gives us a nice decomposition of volatility.

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The Capital Asset Pricing Model
• If we put betas on the horizontal axis, we get the security market line.

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Sharpe’s Comments on CAPM
• Portfolio theory focused on the actions of a single investor with an optimal
portfolio.

• I said, What if everyone was optimizing? They’ve all got their copies of
Markowitz and they’re doing what he says.

• Then some people decide they want to hold more IBM, but there aren’t
enough shares to satisfy demand. So they put price pressure on IBM and up
it goes, at which point they have to change their estimates of risk and return,
because now they’re paying more for the stock.

• That process of upward and downward pressure on prices continues until

prices reach an equilibrium and everyone collectively wants to hold what’s
available.

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Sharpe’s Comments on CAPM
• The CAPM was and is a theory of equilibrium.
• Why should anyone expect to earn more by investing in one security as
opposed to another?

• The key insight of the Capital Asset Pricing Model is that higher expected
returns go with the greater risk of doing badly in bad times.

• Beta is a measure of that. Securities or asset classes with high betas tend to
do worse in bad times than those with low betas.

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One Last Thing
• The beta of a portfolio is the weighted average beta of the securities in the
portfolio.

∑
The proof is straightforward. Take RP = xiRi.
•
i

• The beta of the portfolio can be computed as

Cov ( ∑i xiRi, RMkt) Cov(Ri, RMkt)
∑ ∑
βP = = xi = xi βi.
Var(RMkt) i
Var(R Mkt ) i

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The Capital Asset Pricing Model
• A test of the model (from F. Black, 1993; updated by A. Kolasinski).

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 John and Marsha
• John and Marsha hold hands in a cozy French restaurant in downtown
Manhattan. They have just ordered tournedos nanciere for the main course
and an nanciere for dessert.

• John reads the nancial pages of The Wall Street Journal by candlelight.

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John and Marsha
• John: Wow! Potato futures hit their daily limit. Let’s add an order of gratin
dauphinoise. Did you manage to hedge the forward interest rate on that euro
loan?

• Marsha: John, please fold up that paper. (He does so reluctantly.) John, I love
you. Will you marry me?

• John: Oh, Marsha, I love you too, but . . . there’s something you must know
about me—something I’ve never told anyone.

• Marsha: (concerned) John, what is it?

• John: I think I’m a closet indexer.
• Marsha: What? Why?
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John and Marsha
• John: My portfolio returns always seem to track the S&P 500 market index. Sometimes
I do a little better, occasionally a little worse. But the correlation between my returns
and the market returns is over 90%.

• Marsha: What’s wrong with that? Your client wants a diversi ed portfolio of large-cap
stocks. Of course your portfolio will follow the market.

• John: Why doesn’t my client just buy an index fund? Why is he paying me? Am I really
adding value by active management? I try, but I guess I’m just an . . . indexer.

• Marsha: Oh, John, I know you’re adding value. You were a star security analyst.
• John: It’s not easy to nd stocks that are truly over- or undervalued. I have rm
opinions about a few, of course.

• Marsha: You were explaining why Pioneer Gypsum is a good buy. And you’re bullish on
Global Mining.
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John and Marsha
• John: Right, Pioneer. (Pulls handwritten notes from his coat pocket.) Stock price
$87.50. I estimate the expected return as 11% with an annual standard deviation
of 32%. That’s twice the market standard deviation of 16%.

• Marsha: Only 11%? You’re forecasting a market return of 12.5%.

• John: Yes, I’m using a market risk premium of 7.5% and the risk-free interest rate
is about 5%. That gives 12.5%. But Pioneer’s beta is only .65. I was going to buy
30,000 shares this morning, but I lost my nerve. I’ve got to stay diversi ed.

• Marsha: Have you tried modern portfolio theory?

• John: MPT? Not practical. Looks great in textbooks, where they show e cient
frontiers with 5 or 10 stocks. But I choose from hundreds, maybe thousands, of
stocks. Where do I get the inputs for 1,000 stocks? That’s a million variances and
covariances!
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John and Marsha
• Marsha: Actually only about 500,000, dear. The covariances above the diagonal are
the same as the covariances below. But you’re right, most of the estimates would
be out-of-date or just garbage.

• John: To say nothing about the expected returns. Garbage in, garbage out.
• Marsha: But John, you don’t need to solve for 1,000 portfolio weights. You only
need a handful. Here’s the trick: Take your benchmark, the S&P 500, as security 1.
That’s what you would end up with as an indexer. Then consider a few securities
you really know something about. Pioneer could be security 2, for example. Global,
security 3. And so on. Then you could put your wonderful nancial mind to work.

• John: I get it: Active management means selling o some of the benchmark
portfolio and investing the proceeds in speci c stocks like Pioneer. But how do I
decide whether Pioneer really improves the portfolio? Even if it does, how much
should I buy?
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John and Marsha
• Marsha: Just maximize the Sharpe ratio, dear.
• John: I’ve got it! The answer is yes!
• Marsha: What’s the question?
• John: You asked me to marry you. The answer is yes. Where should we go on
our honeymoon?

• Marsha: How about Australia? I’d love to visit the Sydney Futures Exchange.

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John and Marsha
Problem

(a) The following table reproduces John’s notes on Pioneer Gypsum and Global
Mining. Does adding Pioneer to the market benchmark improve the Sharpe
ratio? How much should John invest in Pioneer and how much in the market?

(b) Repeat the analysis for Global Mining. What should John do in this case?
Assume that Global accounts for 0.75% of the S&P index.

(You don’t need to consider both Pioneer Gypsum and Global Mining at the
same time. You don’t know their correlation, so there is nothing you can do.)

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John and Marsha
Problem

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